Fraud Symptom 3 – Board’s failure to exercise judgment

The board performance and effectiveness differentiates between success and failure of the organization. Before, I mention the details; I am giving a brief background of the Indian corporate sector and relevant laws. Ministry of Corporate Affairs Annual Report 2009 states that there were 821,212 companies limited by shares registered in India. Of these 83,010 were public limited companies and 738,202 were private limited companies. There were 2903 foreign companies operating in India as of 31 December 2009.

Now the question is how this data is relevant. SEBI’s Listing Agreement Clause 49 defines the corporate governance requirements for publicly listed companies in India. That means it is applicable to less than one-tenth of Indian companies.

The clause mentions requirements for independent directors, formation and working of audit committee, corporate governance norms and disclosures, code of conduct etc. The Indian Company Law’s various sections define the requirement for true and fair financial statements, audit committee and corporate governance requirements. However, most of the sections provisions are applicable to public companies and deemed to be public companies. The SEBI guidelines and Company Law requirements on corporate governance are not applicable to private limited companies. Hence, from a fraud symptom perspective, the issues are different and I am dealing with them below separately.

 The most renowned case of boards’ failure to exercise judgment in India is of Satyam. So let me cover that briefly. Satyam’s board consisted of well-known business personalities, namely Mr. Krishna G. Palepu a professor in Harvard Business School and Mr. Vinod Dham known as Father of Pentium. The Central Bureau of Investigation report stated (as given in Top News) –

 “The members of the Board of Directors had acted as “rubber stamps”, unwilling to oppose the fraud. Not a single vote of dissent has been recorded in the minutes of the Board meetings.”

This clearly raises questions on the effectiveness and role of independent directors. Four independent directors of Satyam resigned within a short span after the fraud disclosure. This issue which was brought into focus was “should independent directors be held responsible for the fraud?” The impact was felt across corporate India. The research paper Independent Directors and Firm Value: Evidence from an Emerging Market” mentions that in January 2009 at the time of disclosure of Satyam fraud there was a substantial peak in number of resignations of director. 197 directors voluntarily resigned though their term had not ended. The number consisted of 109 independent directors, 40 insider directors and 32 gray directors. There are certain challenges, which independent directors face in India that may not be applicable to developed countries. I will provide details after covering the SKS Microfinance case that also highlights boards’ failure in business ethics though not in fraud.

SKS Microfinance case came into light when the CEO Suresh Gurmani was unceremoniously fired by the board of directors. There were no performance or fraud issues. Eight of the ten directors voted in favor of his termination, the other two were absent. It is being said that this was done because the founder chairperson Vikram Aluka had some disagreement with the CEO.  Two of its reputed directors are Pramod Bhasin, President and CEO of Genpact and Chandra Shekran, Former Executive Director, SIDBI. This event brought focus to the internal operations of SKS Microfinance. The organization was formed as part of social entrepreneurship to give rural poor and farmers small value loans. It is said that the organization was charging an astronomical 28% interest and was coercing village women and farmers for recovery. A number of farmer suicide incidents were reported to police holding SKS responsible. Andra Pradesh government passed a revised law about microfinance lending which in the last three months has severely affected the microfinance industry. The question here is what was the board doing? Did the directors not question the excessive profits of the company whose objective was social entrepreneurship? Did they ask for information regarding operations? Shouldn’t the board of directors question business ethics of the organization?

The main reasons for failure of independent directors in India are that most of the public listed companies’ shareholding is structured differently. The family or founders bring in their relatives and friends as board of directors and control the organization. The independent directors do not receive insider information of the organization, as senior management is loyal to the founder / family. Hence, all effort is made to protect the family/ founders authority and control, rather than interest of the public shareholders. Therefore, though the qualifications of the directors are good and relevant they have little impact. The directors are appointed more to add prestige to the board and company, a men’s club is formed and nobody bothers to ask the right questions. For the directors it is a status symbol to be on the board, along with the director’s fee, free travel and various indirect privileges. In such a scenario, the board’s independence is lost and there is hardly any focus on curtailing fraudulent activities.  

Next issue to discuss is about private companies. As such, since the number of shareholders is less than 50, in most cases of fraud the financial impact is felt by a small group. The problem arises when the private limited company is a subsidiary of a public limited company or a multinational. According to SEBI Listing agreement  a subsidiary company having a turnover or net worth of 20% of the holding company or has a significant transaction which is more than 10% of its turnover, assets or liability with the holding company has to comply with certain requirements of independent director, audit committee and review by holding company board of directors. However, through multi-layered structuring of private companies, these rules can be circumvented.

As most of the multinationals operating in India have a business process outsourcing or information technology outfit, I am taking an ITES company example to explain how multi-layered structure increases management’s propensity for fraudulent activities. Suppose company “A” is a public listed company in US. A separate private limited company “B” is formed in US with a common founders or board members. Now a separate private limited company “C” is formed in India. Now company A enters into an agreement with company B for providing software development and call center services. Company B enters into an agreement with company C in India for providing the same services. Now let us say majority of the back-office operations are performed by company C in India. Some senior managers maybe reporting to company A and B senior managers. However, now because of the autonomy available to company C and then company B senior managers, the full information does not flow to company A’s board of directors. Hence, the board of directors of company A, whose funds have been used to setup company B and C, would have very little visibility of actual operations. With such minimal control and high autonomy, company B and C senior managers separately or in collision can undertake fraudulent activities without detection.      

Considering the above-mentioned factors, one needs to assess the intent of board of directors. If the intent is wrong, there will definitely be laxity and ineffectiveness.

Recommendations

The board’s independence and critical thinking is necessary for effective corporate governance and preventing large-scale fraud within organizations. The following recommendations are useful from Indian perspective:

1)    Ministry of Corporate Affairs should focus on providing a structure for corporate governance. Applying similar provisions as developed countries is useful, however if similar support structure is unavailable, the provisions become ineffective.

2)    SEBI should delve deeper into appointments of independent directors to ensure that public shareholdings interests are protected.

3)    Reputed professionals who are appointed as directors should fulfill their obligations in true spirit and sincerity. Directorships shouldn’t be just treated as status symbols.

4)    Organizations while forming a multi-layered structure of companies should build processes to ensure transparency and accountability. Procedures for corporate governance should be implemented across the group uniformly.

References:

  1. Ministry of Corporate Affairs Annual Report (http://www.mca.gov.in/Ministry/annual_report_2009.html)
  2. SEBI Listing Agreement (http://www.sebi.gov.in/Index.jsp?contentDisp=Database)
  3. Satyam CBI Report (http://www.topnews.com.sg/content/22973-satyam-scam-board-directors-also-party-fraud)
  4. Satyam Board of Directors Resignation (http://newkerala.com/topstory-fullnews-66077.html )
  5. SKS Microfinance (http://www.sksindia.com/ )
  6. Independent Directors and Firm Value: Evidence from an Emerging Market (authored by: Rajesh Chakrabarti, Krishnamurthy Subramanin and Frederic Tung) http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1631710

To read the full list of Fraud Symptoms, click here.

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16 comments on “Fraud Symptom 3 – Board’s failure to exercise judgment

  1. Pingback: Fraud Symptoms « Sonia Jaspal's RiskBoard

  2. Sonia,

    Thanks for sharing this. Judgment seems to be one of the hardest competencies to develop. Teenagers eventually acquire more of it as they grow into adults — through trial and error and experiencing the consequences of poor judgment. But then it seems to level off or increase slowly with the accumulation of life experience. I know of many techniques for improving decision making and mitigating poor judgment, which I use when facilitating board retreats, but then it re-surfaces with the same people in other circumstances. I need to think more about this. Maybe you have some thoughts on it. I sometimes refer to what I call the “fatal combination” of being highly decisive but having very poor judgment.

    My best,
    Steve

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